Unloved Since Crisis, Value Stocks Seen Leading Fed Rallyby
Undervalued stocks trade at lows relative to growth shares
A Fed rate increase is the signal the market is waiting for
Here’s something about markets that may seem counterintuitive: when economies are struggling to grow, investors usually buy growth stocks, flocking to companies with a track record of improving earnings even when times are tough.
That’s been true during the six-year bull market, a period in which the MSCI World Growth Index has gained almost 40 percentage points more than the MSCI World Value Index. Consumer and technology stocks have led the recovery, outpacing banks and energy companies.
All that’s about to change, according to JPMorgan Asset Management and Barclays Plc, which see the Federal Reserve’s first rate hike in almost a decade as the catalyst that will put a charge in value stocks, roughly defined as those priced at the smallest ratios to earnings and asset value. Raising rates will send a message to investors that it’s safe to take on risk. What’s more, the value gauge trades at its lowest level since the dot-com bubble relative to its growth counterpart.
“Growth styles have done well because we’ve had so much macro-economic uncertainty,” said Louise Kooy-Henckel, a manager of global equities at JPMorgan Asset Management in London. Her firm oversees $1.7 trillion. “Now you’ll have the Fed essentially telling you that the world’s biggest economy is fine. That installs confidence, and it’s just what the value pockets of the market need to do much better.”
Pacific Investment Management Co. agrees, recommending investors increase allocation to value stocks versus growth because of “continued economic expansion and rising rates,” according to a report on its website.
One of the reasons why value shares may rise more with a Fed rate increase is because so many of them are banks. Financial stocks including JPMorgan Chase & Co. and Wells Fargo & Co. make up 30 percent of the MSCI value index. With higher borrowing costs, banks stand to increase their profits, and strategists at Goldman Sachs Group Inc. recommend betting on large U.S. lenders versus the broader market.
Technology and consumer shares are the two biggest industries in the MSCI growth measure. With a valuation of 19.9 times estimated profit, equities in the gauge are 33 percent more expensive than those in its value version.
Value stocks tend to outperform in years of global economic strength. From their low in 2003 to the peak in 2007, they outpaced growth equities by more than 40 percentage points. While they’ve fallen this year, Barclays’s Ian Scott predicts a rebound. He notes a correlation with Treasury yields, which have already ticked up in anticipation of higher rates.
“The market needs a new leadership, and a rotation into value will be positive,” said Scott, Barclays’s head of equity strategy in London. “There’s also a regional aspect to this: growth as a style tends to favor the U.S., whereas a value approach would support equities elsewhere, particularly Europe. Investors can’t really rely on growth stocks or on the U.S. to power the bull market anymore.”
European equities are heading for their first year of outperformance versus the U.S. since before the financial crisis. While the Standard & Poor’s 500 Index tripled from a low in 2009, the Euro Stoxx 50 Index has risen 90 percent. Analysts forecast that profit growth in Europe will outpace the U.S. this year, pointing to another support for the region’s shares.
The question is whether the fragile global economic recovery will hold strong against rising interest rates, a China-led slowdown in emerging markets, and a slide in oil prices. While the major developed economies are projected to expand next year, growth will remain subdued in big players such as Japan or France.
“Yes, the world is a better place than it was three years ago, but the stabilization will take long,” said Alex Scott, who helps oversee about $14 billion as Seven Investment Management’s deputy chief investment officer. “Investors have been skeptical about global growth, and it’s not going to take just the Fed to change that. They need evidence of a protracted recovery. It’s only just been a year since large parts of Europe were still in recession.”
Moudy El Khodr at NN Investment Partners says the Fed has been careful to reassure investors that it will only raise rates when the economy is strong enough to withstand a change in policy. That should trickle down to stock markets, favoring equities that have been left behind in the six-year rally. He recommends banks, steel companies, industrial stocks and is looking at some energy shares too.
“We’ve had a very fearful bull market since the financial crisis,” said El Khodr, a senior investment manager at NN Investment Partners in Brussels. “People were hunting for safety, quality and growth because we lived in a world where that was scarce. If rates go up for the right reasons, then value will benefit. A rate hike would be a sign that the cycle is finally turning more positive than expected.”